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Sunday, April 27, 2008

Fertility, Employment and Inflation in Thailand and Vietnam

"Thailand has even gone the extra mile to explore additional land for rice production," James Adams, World Bank Vice President for East Asia Pacific

The above quote is a reference (of course), to the current global shortage od rice for international trading purposes and to the sudden spike in rice prices (see a much fuller explanation of the whole issue in this companion post). James Adams is simply highlighting one possible step that can be taken, if not towards a complete solution, then at least along the road to an amelioration of what is likely to become - in some of the world's poorer regions - a very acute crisis indeed. But the issue of rice prices (and indeed of the whole structural rise in food and energy prices) is a complex one, and a lot of seperate factors come into play. Land use is simply one of these.

In Thailand’s Than-En village, Phantipa Chongrak, 38 sold her last four-tonne, unprocessed harvest in January for $235 per tonne, half what rice is selling for now in her area. But Ms Phantipa, who owns 1.9 hectares of land, has now bet big on higher rice prices – renting an additional 5.6 hectares to cultivate an unusual out-of-season rice crop, an investment of about Bt150,000 ($4,730, €3,020, £2,380).

Hoping to profit from the soaring price levels, plenty of other Thai farmers have done the same, with Thai agricultural officials predicting an extra 1.6m tonne harvest in June. But that has left Ms Phantipa anxious about her expensive gamble. “I’m thinking and worried that in the next two months the price will be down,” she says.

Obviously the decision procedure facing farmers like Phantipa Chongrak is a complex one. To some extent they need to bet that the rise in prices is going to be more or less permanent (which it may well be) but they will almost certainly be doing this on the basis of very "imperfect information" since they do not have their disposal the sophistocated models and information which international economists can resort to (and god knows, we have a significant enough tendency to get things wrong). So James Adams is right, many in Thailand are preparing to go that extra mile (and let's just hope for there sake that they don't need to "erect one bridge too many" to cover it).

Structural Issues in the Global Agricultural Labour Market

As I say the totality of issues which are being raised by the recent rise in food and energy costs constitute a very complex problem indeed, and in these posts I do not pretend to be able to address all of them. Indeed the question I am raising here is really a very simple one: there is no doubt that globally we have the land surface available to increase agricultural output substantially - even if we should be aware that presently unused land is unlikely to be of the same quality as the land which is being currently put to use (otherwise it is hard to see why it is not currently producing). We also have the technological resources to increase agricultural productivity in a way which enables us not only to feed the additional global population we are facing, but even to meet the needs presented by the rapid rise in living standards which is also taking place in the emerging economies.

We have both of these things (land, technology), but do we have the people we need to put them to work? Or better put - since obviously with those extra billions who are about to come on line across the planet we could hardly be said to be short of people - do we have the right people in the right places? That is to say, do we have the people where we want them, and with the levels of skill and education (you know, to use the technology effectively) that we need? Since if we don't we have what economists have traditionally called a "bottleneck problem", but this time we have it on an unprecedented (global) scale, a scale where the traditional economic remedies (labour market mobility and flexibility) tend to meet with a very high level of cultural resistance.

To take the most simple example, when we start talking about recovering currently unused agricultural land (that extra mile, remember), we might like to stop to think why it stopped being used in the first place. One obvious reason is that it wasn't sufficiently productive at the then prevailing prices, and this will often be true. But another reason would be that growing urbanisation and declining rural populations have simply meant that some land became fallow for demographic reasons (namely that there were not sufficient people willing to stay and work it, at least at the wages which were then being offered), which brings us straight back to my principal point - where and how are we going to find and persuade the people who could work the land to do so. Even the best designed plans - which always look ever so easy and attracive on paper - all too often come to founder on harsh and complex "on the ground" (no pun intended) realities. And if the solution here passes through raising rural wages and rural living standards, then remember that those of us who live in highly urbanised and developed societies may well notice this, in the form of higher prices, continuing inflation in food and energy, and indeed very possibly in a sustained period of what economists like to call "stagfaltion". That is, what we are talking about here isn't exactly small beer.

Migrant Dependence in Thailand

Turning now to a specific example, in the Thai case this whole "where does the labour come from" question is no idle one since fertility - including rural fertility - is now well below replacement level and still falling, and every year less and less young Thais are available to enter the labour market. So basically if the Thais want to work extra land they will need to find the human resources with which to do it.

One option, evidently, is immigration, and the tragic death by suffocation of 54 migrant workers from Myanmar who were being transported into Southern Thailand in an enclosed container truck earlier this month certainly drew the attention of the world's press to existence of this phenomenon in Thailand and to the level of dependence which the current expansion in the Thai economy now has on imported migrant labour. So it isn't only capital which is flowing strongly into Thailand at this point (the astute reader will recall that in fact the Thaksin government actually fell shortly after taking the decision to try to stop too much capital entering the country), labour is also streaming in to allow it to be effectively put to work.

The migrants who died were following a route that tens of thousands of others from Myanmar had taken before them. They are drawn to Thailand to work in jobs described by locals as "dirty and dangerous" - the fisheries industry, construction sector and on rubber and palm oil plantations.

In fact migrant Myanmar labour has long formed a significant part of the workforce who make possible the construction of all those hotels and holiday complexes that now dot the beaches of Phang-nga and Phuket, the mainstays of Thailand's vibrant tourist industry. In the fisheries sector, the men are employed on the boats that go out to sea, while the women work in factories to process the catch.

True, the numbers are not at this point large by Western European and US standards, but they are strategically deployed across the economy. In 2007, Thai labor officials and NGOs estimated that there were some 2 million migrant workers in Thailand, 75% of whom came from Myanmar, while the rest came from Cambodia and Laos. Only 500,000 of these however were registered with the Thai Labor Department.

According to a recent report "The Contribution of Migrant Workers to Thailand" (Main finings online here) prepared for the International Labour Organization by Philip Martin of the University of California (Davis) total migrants in Thailand rose from about 700,000 in 1995 to 850,000 in 2000 and to 1,773,349 in 2005. They constituted 2.2 per cent of the labour force in 1995, 2.5 per cent in 2000, and 5 per cent in 2005.

In 1995 some 42 per cent of the migrants were registered. In 2000 this was up to 67 per cent, but by 2006 it had fallen back again to 26 per cent, with these large fluctuations in the ratios undoubtedly reflecting ambivalence on the part of the Thai authorities to the whole situation. They need the workers, but they don't really want them. How resonant this is of so many situations in so many other countries. Perhaps those who imagine that land can simply be rolled online as we need it (right along a nice simple neo classical production function) might like to think a little more deeply about these kind of issues.

In terms of activities involved, the ILO found that in 2005 the migrants they were able to identify were distributed roughly as follows : 720,000 in agriculture, 720,000 in industry, and 360,000 in services.

Philip Martin calculated - making the assumption that the migrants were as productive as their fellow Thai workers in each of the sectors where they work - that the total migrant contribution to output would be in the order of $11 billion (or about 6.2 per cent of Thailand’s GDP). Assuming they were somewhat less productive (say only 75% of Thai worker output) then their contribution would still be in the order of $8 billion (or 5 per cent of GDP). So we could estimate that migrants in Thailand now contribute anywhere from 7 to 10 per cent of the value added in industry, and 4 to 5 per cent of the value added in agriculture.

Really the picture we are seeing in one country after another across the globe is strikingly similar from this point of view. As countries fall below replacement fertility they increasingly come to depend on migrant labour to work in areas like agriculture, construction, low skilled industry and domestic work. Yet in Thailand, as in many equivalent western countries the new and much needed workers are often far from popular.

Thailand returned to civilian rule in January 2008, with Samak Sundaravej of the People Power Party replacing deposed prime minister Thaksin Shinawatra. The PPP campaigned on a populist platform aimed at reducing rural poverty, and said it would use its first six months in office to revive the economy before tackling controversial issues, including migration.

The military government that ruled between September 2006 and January 2007 had taken a hard line against migrants from neighboring countries, supporting five southern governors who banned migrants from talking on cell phones, riding motorbikes, or leaving their Thai housing between 8pm and 6am. However, faced with the inevitable it did prove to be just as flexible as governments elswhere at the end of the day and finally approved a plan to allow migrants who failed to re-register in 2007 to pay a fine (3,800 baht, $120) and register for two-year work and identity cards during January-February 2008.

As I have said most migrants in Thailand are employed in low paid unskilled jobs in construction, manufacturing, agriculture, fisheries and domestic service in northwestern and southern provinces. Relatively few jobs held by migrants are attractive to Thais and few migrants work in the areas of highest unemployment in Thailand's northeast. The apparent magnitude of migrants' contribution to Thai GDP and their sectoral concentration suggests that they will continue to contribute substantially to the country's economic development for the foreseeable future.

The Vietnamese Case

But turning now from a country which is below replacement fertility and importing migrants, to one which is below replacement and exporting them, let's examine the case of another of the world's leading rice exporters - Vietnam - which is in fact the third exporter globally after Thailand and India. As can been seen in the chart below, Vietnam has enjoyed very rapid economic growth in recent years, especially when measured in US dollar terms, and this economic growth has both raised living standards and expectations, and reduced productive land available for rice cultivation.

As I have been trying to argue, the issue of rice prices (and indeed of the whole structural rise in food and energy prices) is a complex one, and a lot of seperate factors come into play. Land use is simply one of these: Vietnam’s total paddy acreage has dropped from 4.3m hectares to 4m hectares in recent years, and part of the reason for this has been increasing pressure on land use from other areas like industrial development and housing. Of course, raising output is not incompatible with using less land, providing productivity rises fast enough, but this (as we will see later) is not always as easy as it sounds on paper. A second factor which is also important is inflation - and again as we will see, Vietnam is now suffering from a fierce bout of inflation - since rapid rises in the prices of some basic commodities can lead to hoarding in the expectation of future price increases, and the only way to halt this is to convince people that prices will stabilise, something which in the present climate is very hard to do indeed. Basically a combination of rapidly rising living standards and an increase in inventories for "hoarding" purposes can provide us with a large part of the explanation for why it is that despite the fact that Vietnam has now ceased to export rice the queues to be found in Ho Chi Minh city are currently longer than anything which has been seen since the height of the communist era.

But things are not, as we have been seeing (in, for example, this accompanying post on the roots of the problem) as simple as we - or classical economic theory - might like them to be, since many things are interconnected here, and in fact far from being able to simply breeze that extra mile that James Adams is rooting so hard for, Vietnamese farmers are currently losing thousands of dollars every year as a result of manpower and machinery shortages when it comes to harvesting the rice they would evidently like to grow.

Provinces in the Mekong Delta region continue to face a lack of workers to harvest crops.

At least this is the situation described in a recent survey carried out by Can Tho University, and the problem has now started to become an acute one since - owing to Vietnam's spectacular recent growth (see above chart) - potential young farmerworkers are leaving in droves for urban centres, industrial parks, export processing zones or points farther afield (external migration), in search of jobs which offer better pay, and given the collapse in Vietnamese fertility which has taken place since the late 1980s, there are now, in a fashion which is eerily similar to the pattern we have already been noting in China, fewer and fewer young workers about to enter the Vietnamese rural labour market, creating a potentially huge long term labour gap in areas like the Cuu Long (Mekong) Delta (Viet Nam’s biggest breadbasket).

For Vietnamese farmers, the sharp rise in rice prices comes amid rapid change in the rural landscape. Vietnamese rice farmers today are far more productive, and prosperous, than they were during the ill-fated, and long abandoned, drive to collectivise agriculture. But in the new drive for nationalisation, much prime paddy land is being converted to factories and housing.

According to Hanoi’s Institute of Policy and Strategy for Agriculture and Rural Development, Vietnam’s total paddy acreage has dropped from 4.3m hectares to 4m hectares in recent years, which has raised concerns about the country’s long-term food security. “We are warning against diverting [rice] paddy land to other uses,” says Duong Ngoc Thi, a senior official at the institute.

Of course increased investment in improved technology would help - a combine harvester operated by three people has the manpower equivalent of 100 farmers - but apart from finding the money to make this work, the techno-fix is not that simple since Vietnamese paddy fields are wet and muddy compared with the waterless fields which serve for other crops, and this makes it much harder for foreign-made, modern machines to work well in them.

Nonetheless an increase in investment would undoubtedly help the Vietnamese rice industry avoid so much of its potential crop each year, according to Nguyen Van Chien, an official from the Vietnamese Ministry of Agriculture, and agricultural mechanisation could help enhance the quality as well as the quantity of Vietnamese rice, boosting the country’s competitiveness for rice exports with its chief rival, Thailand. At present, Vietnamese rice sells for around $20 less per tonne than Thai rice.

Of course, it is important to bear in mind that despite the dramatic drop in fertility Vietnam's population is still rising fast. This is the so-called "momentum problem", since the last cohorts from the high fertility era are very numerous, and thus when they reach childbearing age will tend to produce a large number of children, even if the number each individual woman has is a lot less than previously. In addition we need to add-in the impact of increased life expectancy as rising living standards improve the general health of the population. So Vietnam's population is both increasing, and ageing rapidly, and this latter issue will undoubtedly have significant consequences later on.

It isn't only in rural Vietnam, however, that labour shortages are now appearing. The Ho Chi Minh City Construction Association has forecast that this year the city will face a labour shortage in the construction industry since the number of building projects awaiting execution has doubled. In a recent report they noted that the shortage problem got significantly worse in the post-Tet holiday period, since (and in an example which follows a pattern we have already seen in China) many young workers did not return to their jobs after the holiday. Most construction companies have been busily raising wages in an attempt to entice more people yet the shortage persists. Nguyen Huu Quang, deputy director of the NBH Building Service Ltd. Co, is quoted as saying that construction companies in HCM City were in danger of losing a significant part of their human resources.

As I mentioned, this failure of people to return after the Tet holiday is surprisingly reminiscent of the situation as reported in China after the end of the recent winter holdiday. The Economist - in an article entitled Where is Everybody - reported that the vast annual migration of around 20m people that has been fuelling the manufacturing boom in southern China over the past two decades is now rapidly diminishing.

The Guangdong Labour Ministry is reporting that 11% of the workers did not return after the January holiday period, and independent estimates put the number as high as 30%. Whatever the exact details, many factories are reeling. Wages were already rising (according to government figures by around 20% y-o-y) now they will surely go up further. Meanwhile, revenues are falling due to slowing demand from America and a reduction, following pressure from other countries, in China's complex system of export subsidies.

According to HCM association’s figures, construction companies in HCM City currently can supply more than 42,000 skilled masons, a number which is far below the real demand for workers, which is thought to be somewhere in the region of 100,000. In a trend which has been evident in other countries (like Eastern Europe) skilled construction worers have either transferred to other provinces (or gone abroad) or returned to their hometowns where better infrastructure now exists and a rapid rise in the construction of industrial parks and export processing zones is producing plenty of work.

And what is the result of these growing labour shortages? As we have been seeing elsewhere (and again the East European comparison is instructive) the outcome is virtually inevitable: rapidly rising wages and accelerating inflation. Vietnamese consumer prices rose 21.4 percent in April, the fastest pace since at least 1992 and the IMF are now forecasting annual inflation of 16% for the whole of 2008 in Vietnam.

These growing labour shortages, which can to some extent be anticipated in any economy which is growing rapidly, are exacerbated in Vietnam by the fact that many potential workers - in a way which is similar to the situation which is to be found in Poland or Romania - now work abroad, whether as temporary or permanent migrant labour. There is, however, one important difference between Vietnam and Eastern Europe in this regard in that Vietnam has an active policy of encouraging what they call "labour Export", indeed the Ministry of Labour has a whole department which is dedicated to the topic. The reason that this policy is persued is not hard to imagine. It is summed up in one single word: remittances. For 2006 the World Bank estimates that migrant workers sent home to Vietnam roughly $4.8 billion, or 7.5% of GDP.

As I say, it is not simply a question that people from Viet Nam want to go to work abroad, the Vienamese government is actively encouraging the process. As a result the number of foreign destinations has been expanding significantly. There are now more than 40 countries to which Viet Nam "exports" labour, compared with 15 in 1995. The Vietnamese labour market generated about 1.68 million new jobs in 2007 according to the Ministry of Labour, Invalids and Social Affairs. About 1.6 million of these new jobs were generated inside Viet Nam, but about 85,000 were jobs abroad, and these brought the total number of Vietnamese guest workers and experts officially working abroad to over 400,000 in 2007. And the Labour Ministry is working on further expanding the business, since it has plans to raise the rate of "exported labour" at an annual additional rate of 40,000 to 50,000 (to around 130,000 annually) by the time we get to 2010, an increase of 65 five per cent over a five-year period.

Job seekers at a recent employment exhibition held in Ha Noi. Obviously given the wage differentials which exist people are eager to leave, but should the Viet Nam government be actively promoting the process? In the short term it eases pressure on the labour market, but at what price in the longer term?

One destination which is proving increasingly popular is South Korea, and the Vietnamese Ministry of Labour recently proudly announced that Korean companies would like to recruit 15,000 Vietnamese guest workers in 2008, 27 per cent more than last year. In addition the Korean Government has decided to allow 1,000 migrant Vietnamese labourers who had originally registered for agriculture work to transfer to construction, which is itself suffering from a shortage of workers, according Vu Minh Xuyen, vice director of the External Labor Center of the Vietnamese Ministry of Labour.

Xuyen said the workers will have to take an exam testing their understanding of the Korean language. The exam can be taken in May or October. Those living in remote areas and poor rural areas will be given priority.

Workers seeking South Korea employment learn Korean at a job service centre in the Central Highlands in Gia Lai Province. Korean company demand for Vietnamese guest workers this year is 27 per cent up against last year.

Of course South Korea is facing its own low fertility driven labour market issues. According to U.N. statistics, the fertility rate per women has fallen from 5.4 in 1995 to 1.5 in 2005 with the estimate for 2050 being 2.1. The population in the age group of 15-59 it is estimated to fall from 68.2 percent in 2000 to 50.4 percent in 2050, whereas the share of 60 plus population is to rise from 11 percent in 2000 to 33.4 percent in the same time span.

Recent statistics show that South Korea's birth rate fell to its lowest (in 2005). The projected (Health-Welfare Ministry forecast) fall in population from the present level of 48 million to 40 million will occur over next 45 years. The ageing index (U.N. statistics) is projected to grow from 52.7 in 2000 to 150.7 in 2025.

In a recent Korea National Statistical Office report, this index is forecast to reach 100.7 in 2016, almost doubling from 55.1 in July 2007, further projected to as high as 213.8 by 2030. This will put a tremendous financial burden on the working-age population (those aged 15 to 64), to support those elderly citizens, while the ratio of the working-age population to senior citizens is predicted to drop to as low as 2.7 per one elderly by 2030, as compared to the present level of 7.3 to 1.

So naturally Korea is going to increasingly need to import labour, and my only question is: does it make sense to import this labour from a country like Vietnam which itself is also going to be having problems over a fairly limited time horizon?

The point is economic growth of the kind Vietnam would like to have is very employment intensive. At the end of 2007, there were more than 45.6 million Vietnamese employed nationwide, an increase of 2.31 per cent over 2006, and the Ministry of Labour plans to generate a further eight million new jobs by 2010. This objective was recently announced by Dam Huu Dac, deputy minister in the department, who said it was part of a National Target Programme on Job Generation. "Each year, 1.5 to 1.6 million new jobs are being generated and a total of 49.5 million workers are expected to be employed by 2010." he said. And this is just it, right now Vietnam has a massive problem of job creation quite simply because the number of people of working age has been expanding rapidly, but soon, following that sudden turn downwards in the 15 to 19 age group curve, the problem will be inverted, and having constructed an economiy which needs and extra 1.6 million workers a year to keep moving the issue will be one of just where those workers are going to come from?

About 1.6 million seek to enter the Vietnamese labour market every year. Meanwhile, the nation’s population is growing by more than a million annually.

The question I am asking is really one about our whole perception of the ongoing demographic transition. Does it really make sense for a country with such low fertility as Viet Nam now has, and where labour shortages in rural areas and key sectors like construction are already being observed, to be so enthusiastically exporting - in a way which is very reminiscent of Eastern Europe - its future labour force? As I say, the issue here is as much one of changing how we see the situation as anything else, and getting it across to those responsible for making economic policy that "cutting your nose of to spite your face" may work in the short term, but in the longer term we are only building up problems, and big ones.

The Czech Connection

The story I am telling here is one of a web with many loose threads. And I wouldn't want to give the impression that I am arguing against labour mobility, far from it. I think that immigration from high fertility countries to lower fertility ones makes a lot of sense. What I am questioning is the movement of population from low fertility societies to higher fertility ones (from Poland and Latvia for example to the UK and Ireland, or from Ukraine to virtually anywere), and I am also questioning the advisability of countries which are attempting to grow rapidly while having falling and below replacement fertility actively encouraging and stimulating out-migration. At best this is simply moving the deckchairs round, and at worst it is robbing Peter to pay Paul when Peter is already out of money.

The strangeness and lack of apparent rationality in all of this is perhaps nowhere better illustrated by the close and growing connection between the Czech and the Vietnamese labour markets. The Czech Republic's economy is growing rapidly - around 6% to 7% per annum -and unemployment is amongst the lowest in the European Union. As a result the Czech Republic is now itself growing very short of labour (only 3 years after watching a stream of its own young people leave for work in the UK and elsewhere), since after 20 years of very low fertility (1.2-1.3 TFR range) there are now fewer and fewer young people coming forward into the labour market, and so, of course, the Czech Republic is busy out and about looking for migrants to fill the gap.

Initially they turned to their immediate neighbours, and indeed the largest group of foreign migrants with rights to work in the Czech Republic comes from Slovakia. At the end of last year, there were 101,233 Slovakians legally working in the country. Ukranians are the second most numerous group with 61,592 working in the Czech Republic as of last year. But there are problems here since both of these countries (and indeed all the other ones in the region) have very low fertility too, so they soon notice any drain on their labour resources, and this is then simply displaces a problem from one place to another and is not a long term solution.

As a result the Czech government is now looking further afield - much further in fact - since the number of Mongolian and Vietnamese workers working in the Czech Republic has been increasing rapidly. In 2007 there were 6,897 Mongolians working legally in the CR (up from 2814 in 2006) and 5,4425 Vietnamese (up from 692 in 2006). The numbers of Vietnamese present in the country is undoubtedly much larger, and according to the Czech police, there are almost 51,000 Vietnamese holding long-term or permanent residence permits for the CR, many of these associated with temporary student visas. Demand from people inside Vietnam is also way up, and the Czech embassy in Hanoi had to close its doors to visa applicants temporarily in March to reorganise itself in order to cope with the influx.

So you plug one gap to create another, and where I ask, is the method in all our madness here?

In this post I have not presented solutions, rather I have attempted to identify problems, problems which need to be addressed. But in order to adequately start to address the problem we need first to recognise that it exits. Basically I feel that far too many people - and especially at the institutional level - are still effectively in denial that the problem exists, and is important. What I would like to ask is when is someone (someone with some clout I mean) finally going to start taking seriously the idea that emerging economy countries like Vietnam need to try and do something about their fertility situation (and that something will undoubtedly involve dedicating resources to the issue) before they get stuck - like South Korea, Singapore, Taiwan and Hong Kong before them - down on that very bottom rung?

Food Prices, Farmland, Global Rebalancing and Rural Labour Shortages

Ukrainian President Viktor Yushchenko said last week that he had agreed to let Libya grow wheat on 100,000 hectares of land in the Ukraine. In exchange, Libya promised to include the former Soviet republic in construction and gas deals.
With so many interesting debates going on the Demography Matters blog at the present time I find it hard to pull myself away, but I couldn't help getting drawn into the implications of the points raised by this article in the Financial Times about how the global pressure on food supplies and the rapid increase in prices is now leading to an equally rapid increase in the price of farmland in one country after another. And then, thinking about a country like Ukraine - with a declining population, rapidly falling unemployment, and growing labour shortages - I couldn't help scratching my head and asking myself, but just where are they going to get the labour force from to work all this extra land they want to cultivate?

But lets get back to land prices for a moment. According to the Financial Times with prices of commercial and residential now property falling in many developed economies, investors are begining to find themselves faced by a rather tricky problem set: they can either stick all those millions (or bliions) which they no longer feel happy to place in first world property into a novel value store like food (and start for example hoarding rice, or buying soy futures) or they can turn their attention towards a more traditional and well established asset: farmland. Long seen as a declining sector, agriculture has just received an enormous fillip as global demand for food has skyrocketed. As a result, the value of agricultural holdings across the European Union has been rising to record levels.

In the UK prices have risen by 40 per cent over the last year alone, and there is apparently plenty of room for prices rises across the whole continent. In Lithuania - to take just one example - a hectare of agricultural land was estimated to cost €734 ($1,167) in 2006 compared to €164,340 in Luxembourg (which was Europe's most expensive country at the time). In Poland average prices for farmland are estimated to have risen by 60 per cent between 2003 and 2006. In neighbouring Ukraine – not an EU member – prices for the best land are forecast to double this year from the 2007 value of $3,500 per hectare as one investment fund after another piles in (you know, all those pensions people will be looking to receive later). Even Serbia, another non-EU country, has seen a steep increase. Real estate analysts estimate arable land prices in Serbia’s agriculturally rich northern region, Vojvodina, at roughly €7,000-€8,000 per hectare this year, up sharply from €5,000 last year.

Even in distant Afghanistan the rise in the value of conventional farming is being noted, since opium crop is forecast to shrink by as much as half this year after 2007’s record harvest, according to counter-narcotics officials in Kabul, as evidence grows that poppy farmers are switching to legal crops, attracted by the rising food prices.

All of this raises a number of very interesting questions, not least of them being why it is all happening now (number one), and where many of these countries who have surplus land to offer- but have had congenitally low fertility for longer than I now care to remember, and have been busying temselves over the last few tears exporting what scarce labour resources they have to Western Europe or Russia (Latvia, Lithuania, Ukraine, Poland, Slovakia, Romania, Bulgaria etc) are going to find the labour forcethey would need to work the extra land (number two).

Why The Price Rise Now?

Well on the first point, I really can't do better than direct your attention to another very interesting article in the Financial Times, this time one from Martin Wolf, entitled "A turning point in managing the world’s economy". Wolfe's main point for our present purposes is this one:

"As the latest World Economic Outlook from the International Monetary Fund remarks, “the world economy has entered new and precarious territory”. What are perhaps most remarkable are the contrasts between booming commodity prices and credit-market collapses and between buoyant growth in emerging economies and incipient recession in the US. So where are we? How did we get here? And what should we be doing?"
The point to notice here is that it is not just investment funds who are busy adapting their behaviour since we all have a rather novel problem set on our hands, as the credit crunch wends it way forward and property markets drift (at best) into stagnation in one OECD economy after another, commodity prices are rocketing, and the best bet at this point is that the developed world is heading towards a protracted bout of stagflation (where central banks are constrained to operate a tight monetary policy, keep credit on a tight rein and basically restrain growth to contain inflation), while emerging market economy after emerging market economy (of course it is not quite as simple as this) seems to be revving up on the development ramp prior to launching into "we got lift-off" mode.

The April 2008 IMF World Economic Outlook estimates that the US economy may shrink by 0.7 per cent between the fourth quarter of 2007 and the fourth quarter of 2008, and eurozone growth is expected to fall to some 0.9 per cent or so this year, yet while the most important high-income economies stumble (even where they do not actually fall), the picture in the majority of emerging economies is for only modestly diminished growth, with rates of 7.5 per cent being anticipated for emerging Asia ( with China on 9.3 per cent and India on 7.9 per cent); 6.3 per cent for Africa; and 4.4 per cent in the western hemisphere. These latter are certainly not growth rates to be sneezed at.

But what we have going on here is not only a growth rate differential, it is also a massive currency re-alignment. The consequential rapid and dramatic rise in dollar GDP values (produced by the combination of strong growth and the declining dollar) means that convergence in global living standards - at least in the cases of those economies who are experiencing the strongest acceleartion - is now happening much more quickly than anyone could have - even in their wildest moments - dreamed back in the 1990s. All of this is very well illustrated by the case of Turkey, as can be seen in the chart below.

According to Wolf:

Emerging economies have been the engines of growth over the past five years: China accounted for a quarter; Brazil, India and Russia for almost another quarter; and all emerging and developing countries together for about two-thirds (measured at PPP exchange rates) of world growth. Furthermore, notes the WEO, these economies “account for more than 90 per cent of the rise in consumption of oil products and metals and 80 per cent of the rise in consumption of grains since 2002” (with scandalously wasteful biofuels programmes contributing most of the remainder).

This situation can be observed quite clearly in the two charts which follow, which are based on calculations I made last autumn from data available in the IMF October 2007 World Economic Outlook database. Now, as can be seen in the first chart the weight of the US economy in the entire global economy has been declining since 2001 (and that of Japan since the early 1990s). At the same time - and again particularly since 2001 - the weight of the so- called BRIC economies (Brazil, Russia, China and India) has been rising steadily.

This is just one example - and a very basic one at that - of why Claus Vistesen and I consider that demographics is so important, since it is precisely the population volume of the BRIC (and other similar) countries and the fact that they start their development process from such a very low base ( ie there is such huge "catch-up" potential since they were allowed to become so comparatively poor, for whatever reason) that makes this transformation so significant.

Again, if we come to look at shares in world GDP growth we can see the steadily rising importance of these BRIC economies in recent years and the significantly weaker role of "home grown" US growth. In 1999 the US economy represented 30.91% of world GDP, and in 2007 this percentage will be down to 22.4% (on my calculations based on the forceast made by the IMF in October 2007). In 200 the US economy accounted for a staggering 40.71% of global growth, and by 2007 this share is expected to be down to 6.43%.

But most of the data I present above predate the financial market turmoil of August 2007. In fact what has been happening post August 2007 is really fascinating and actually quite unique, since following the breakdown we have seen in some of the world's leading wholesale money markets - and in particular in the securitised-mortgage-paper based ones - the credit system in all the G6 economies is steadily slowing - and all the world's major developed economies are gradually entering recession. All the major developed economies, but not, of course, the newly developing ones, as I am indicating.

This state of affairs may well now become a relatively drawn-out affair since the structural rise in food, energy and commodity prices that is being produced by such a dramatic rise in living standards in the world's most populous countries means that we are likely to have continuing high structurally driven inflation, and to this needs to be added a longer term relative downward drift in the value of G6 currencies vis a vis emerging economy ones (the euro has still to feel the force of this, since recently it has simply risen and risen, but I think it will come, while the dollar case is already clear enough) means that in the OECD world we are more than likely in for a protracted dose of stagflation, as central banks on the one hand are constrained from too much monetary easing by inflation concerns, while the credit crunch on the other seems to imply that cheap mortgage and personal finance is unlikely to become so widely and freely available as it was, whatever the base interest rates at the central banks.

Yet unlike previous recessionary occassions (arguably ALL such previous occasions in living memory) funds are not coming running home to the G6 economies for safe cover during this downturn. Instead they are in a kind of headlong flight towards the emerging ones: hence the steady fall in the dollar, and the rise in currencies like the Turkish lira, the Brazilian real or the Indian rupee. In these countries it is literally raining money (saving good old Ben the trouble of having to get his helicopter out). We could take the Indian case as a clear example here.India's foreign exchange reserves (which are a reasonably proxy for the rate of capital inflows) rose $2.7 billion to touch $311.9 billion during the week ended April 4, and this is a rise of some 50% on the level of $204 billion which existed in May 2007.

At the same time, and despite having fallen back somewhat recently, India's rupee is up substantially against the dollar, perhaps by 12% across 2007 as a whole.

What this really means to me is that the damn has finally burst - and that the huge accumulation of population at one pole of the planet and of wealth at the other is now in the process of unwinding itself - and really there is no turning back. Country after country is now hitting the development high road and this will not only have an impact on the rate of global population growth (slowing it markedly), global fertility (ditto) and global ageing (in this case we are likely to see an acceleration, as improving health increases life expectancy, while declining fertility reduces the size of the younger cohorts), it will also put enormous short term pressure on the supply of global resources, and it is on this issue that I really want to focus here.

The picture is that not only is population growing rapidly in some developing countries (foreseen), but both population and per capita living standards are growing (not foreseen) - and indeed these living standards are rising so fast that the gap between some of the leading countries and the developed economies is closing rapidly. This latter - unforeseen- effect is the principal reason we are seeing such acute pressure on the global supply of agricultural products.

One of the obvious reasons for such a sharp rise in demand for agricultural products is that food consumption forms a much greater part of the extra income earned in a poor country than it does in a rich one. As a rough and ready rule, the poorer the country the greater the share of every extra dollar earned which will be spent on food.

To take the example of Russia, Russia's very rapid economic growth since the turn of the century is producing an equally rapid rise in incomes and living standards. According to the Russian Statistics Office Rosstat, average real wage and disposable income increased by 16.2 and 12.9 percent, respectively during the first nine months of last year, and increases of this order, when coupled with currency changes, produce a very sharp rise in purchasing power, as can be seen in the chart below.

The consequence of rapid growth in a tightly constrained labour market like the Russian one isn't hard to predict: rampant inflation. In fact Russian consumer price inflation accelerated in March to hit an annual rate of 13.4% (Bank of Russia data), up from 12.7% in February, and led by bread, vegetables and other food costs. Prices rose 1.2 percent from February. Russian prices have already risen by an icredibly 4.8 percent in the first three months of this year alone (January to March).

And if we come to look for a moment at the components of Russian inflation (see charts below) we will find two of our old friends out there in the forefront - food and construction. In fact in the first 10 months of 2007 the rate of increase in construction costs was some 15% (as compared to only 9% during the equivalent period of 2006). And if we look at the chart for Russian CPI weightings (see below, - and note by way of comarison that in China and Turkey, food related products also constitute around 25% of the CPI basket).

And again here Russia is a nice example of the extent of this problem, since Russia's manpower shortages (see this post) mean that supply in the agriculture sector is now pretty constrained, while technological improvement if investment totals are anything to go by is not notably accelerating. Investment in transport and communication constituted 23.31% of total investment in Russia the first half of 2007, investment in real estate constituted 12%, and investment in agriculture constituted only 4.7% of the investment total.

In terms of FDI the situation seems to be even worse, since FDI in Russian agriculture only constituted 0.7% of total FDI during the same period (World bank data). As a result of all this neglect it should come as no surprise to find that labour productivity in Russian agriculture only grew by 4.4% per annum over the 1999 - 2004 period (the lowest by a long way for any sector, World Bank calculations), and thus starved of its workforce, and lacking the necessary capital investment to compensate, Russian agriculture is bound to struggle to meet the needs of an ever more affluent urban population. The result of course is that Russian inflation is now spiralling upwards almost out of control.

Rice As An Example of What is a Global Problem

Thailand's benchmark 100 percent B grade white rice was quoted at a record high of more than $1,000 per tonne last Thursday as a result of constrained supply and rising demand as governments in one rice producing country after another consider taking steps to restrain exports. The price was up from around $950 per tonne a week earlier and $383 per tonne in January. Thailand is the world's number one rice exporter and exports almost twice as much rice as India, its nearest rival.

In fact Thailand produces about 22 million tons of milled rice annually and exports about 10 million tons. The sharp spike in prices was produced by a report from a World Bank official earlier in the week, and prices did subsequently fall back again after Finance Minister Surapong Suebwonglee siad reassuring words to the effect that Thailand has no plans to limit rice exports.

``If a key exporter like this limits foreign sales, it would be very much like Saudi Arabia reducing oil exports,'' said James Adams, vice president of the bank's East Asia and Pacific department.

Several of the world's food producers - including Egypt, Vietnam, China and India - have recently placed restrictions and limits on food exports in an attempt to contain domestic prices and to reduce protests from urban consumers. Brazil - which this year should harvest an 11.9 million ton rice crop, up from 11.3 million last season - was busy backtracking at the end of last week on an earlier decision to restrict exports. Brazil's Agriculture Minister Reinhold Stephanes followed the example of his Thai counterpart and stated that Brazil would not, in the end, curb exports. Pakistan is also stepping up to the plate in what has virtually become a global emergency and has stressed it has plans to export 2.5 million metric tons this year, according to farm minister Chaudhry Nisar Ali last week.

Vietnam, however, which is the world's third-biggest rice exporter (after Thailand and India), is going to go ahead and reduce rice shipments by 11 percent this year to 4 million tons to ensure supplies and attempt to curb inflation that is its highest in more than a decade (see more on Vietnam in this post). In doing this Vietnam is following in the footsteps of the world's number two rice exporter - India - whol last month put significant restrictions on the export of rice.

Indonesia, which is the world's third-largest rice producer (as opposed to exporter), also intends to hold back surplus rice from export this year in order to bolster domestic stockpiles, according to President Susilo Bambang Yudhoyono speaking on April 18. Export restrictions are particularly threatening to the large rice importers whose populations ofetn depend of the staple for their basic food supply. The Philippines was the world's largest largest importer last year, followed by Nigeria. The Philippines received offers for only two-thirds of the grain it sought to buy on April 17.

Rice is in fact the second largest produced cereal in the world. At the beginning of the 1990s, annual production was around 350 million tons and by the end of the century it had reached 410 million tons. World production totaled 395 million tons of milled rice in 2003, compared with 387 million tons in 2002. This reduction in total output which occured around the turn of the century is largely explained by the strong pressure which have been placed on land and water resources, which led to a decrease of seeded areas in some Western and Eastern Asian countries.

Production is geographically concentrated in Western and Easter Asia which account for more than 90 percent of world output. China and India, between them host over a third of the global population supply over half of the world's rice. Brazil is the most important non-Asian producer, followed by the United States. Italy ranks first in Europe.

Growth has however been far from linear. Historically, production in ex-Japan Asia has increased steadily but at the end of the 1990s Asian output started to stagnate and in particular in China where rice areas have declined as a consequence of water scarcity and competition from more profitable (oleaginous) crops.

The international trade in rice is estimated between 25 and 27 million tons per year, which is only a very small part (5-6 percent) of total world production., and this makes the international rice market one of the smallest in the world when compared with other grain markets such as wheat (113 million tons) and corn (80 million tons). It also means that the price level is very sensitive to comparatively small changes in some key exporters.

Besides the traditional main exporters (Thailand, Vietnam, India and Pakistan), a relatively important but still limited part of the rice which is traded worldwide now comes from developed countries in Mediterranean Europe and the United States. There are two major forces behind this: new food habits in developed countries and new market niches in developing countries.

(please click over image for better viewing)

As we have seen, rapid eceonomic growth across Asia is now putting enormous pressure on food prices. Consumer prices in China, the world's fastest-growing major economy, soared 8.7 percent in February, the fastest pace in 11 years. In Thailand, inflation is running at 5.3% (March) but this is still enough to worry the government, while in Vietnam, inflation jumped to 19.4 percent this month, the fastest pace since July 1995. Vietnamese food prices jumped 30.6 percent from a year ago, with the component including rice leaping 30.1 percent from March 2007 and 10.5 percent from February 2008.

The Food and Agriculture Organization said in February that 36 nations including China face food emergencies this year. World rice stockpiles may total 72.1 million metric tons by end of July, the lowest since 1984, the U.S. Department of Agriculture said.

Prices of agricultural commodities are also being driven by investors looking for alternatives as the dollar and stocks drop. Global investments in commodities rose almost 33 percent to $175 billion last year, according to Barclays Capital. The UBS Bloomberg Constant Maturity Commodity Index of 26 raw materials climbed to a record on Feb. 29 and is up 16 percent so far this year.

But not everyone wants to restrain exports. Rubens Silveira commercial director of Rio Grande do Sul state's Rice Institute said the state - Brazil's No.1 rice grower - should export about 10 percent of this years crop at current prices, and argued that these exports will both help support domestic prices and provide incentives to producers to invest in improving output. Mainstream economists tend to agree with him:

``Limiting exports is pure politics and bad economics since export controls destroy the incentive of farmers to plant more rice,'' Nobel laureate Gary Becker, an economist at the University of Chicago, said in an interview. ``But governments tend to favor the urban workers over the farmers, since urban groups are more politically active.''

And it isn't only rice that is under pressure. Wheat prices are also rising fast. Wheat for July delivery was trading at around $8.1750 a bushel on the Chicago Board of Trade last week, down from the February peak, but still up 62 percent in the past year. Global wheat production is expected to rise 6.8 percent in the 2008-09 season as record prices spur farmers to sow more, the International Grains Council said last week. Wheat output is expected to climb to 645 million tons from 604 million tons this season, according to the London-based council. Inventories are forecast to gain 12 percent to 128 million tons, led by an increase in the U.S.

Global wheat production will advance approximately 6 percent in 2008 over 2007 - to an all-time high of 640 million metric tons - as record prices spur farmers to grow more according to Rabobank estimates. That is 37 million metric tons up on output in 2007 . Plantings will also gain 5 percent and global stockpiles will rise 9 percent they suggest. But then we might like to note that even with a 6% growth rate in output (which is no mean rate of increase) prices have still risen by 62 percent. This gives us some measure of the scale of the problem.

The prices of wheat, corn, rice and soybeans have all risen to record levels this year on shrinking global stockpiles and rising demand from the food, feed and biofuel industries. The rally has meant higher costs for everything from Italian pasta to Japanese noodles, and spurred street protests from Haiti to Ivory Coast.

``We have been neglecting our basic rice production infrastructure and research and development for 15 years,'' said Robert Zeigler, director-general of the International Rice Research Institute in the Philippines. ``

India's output is increasing rapidly, but so is demand there, as high rates of economic growth boost incomes. Indian wheat output may climb to 76.8 million tons this year, according to India's agriculture secretary PK Mishra. That's up on the 74.8 million tons estimated in February and up from 75.8 million tons last year. Indian rice output is also expected to rise to a record 95.7 million tons, from the 94.1 million tons estimated on Feb. 7. That's 2.5 percent more than the 93.6 million tons produced a year earlier, but still far from enough to stabilise Indian wholesale prices which are now running at the fastest pace in nearly three years.

Labour Supply

"Thailand has even gone the extra mile to explore additional land for rice production," James Adams, the bank's Vice President for East Asia Pacific, said in a statement.

But with countries as far apart as Ukraine and Thailand (where fertility in each case is already well below replacement level, see here for Ukraine, and here for Thailand) moving to open up more land for agricultural production, we may well want to ask ourselves just where the anticipated manpower is going to come from. Ukraine is already suffering from severe labour shortages as most of its immediate neighbours (and in particular Russia) have sought to resolve their own labour shortage problems by importing Ukrainian migrants. Now the labour shortages back home are producing yet another a massive inflation bonfire:

Since this post is already inordinately long, I am continuing the labour shortage part of this study, in a separate post focusing on Vietnam (which can be found here).


So what is the point - at the end of this very long and tortuous post - that I am actually trying to make here.

Well I think my points would be several.

1/ Firstly and most obviously that the current increase in global commodity prices is NOT simply a monetary phenomenon. Of course it IS a monetary phenomenon, since without he money, as the economic "smart-aleks" likie to point out you can't have the inflation, but it is not SIMPLY a monetary phenomenon, since it is underpinned by profound structural changes in the real economy, structural changes which are taking place on a global scale. Under such circumstances traditional monetary policy is in fact rather limited in its ability to substantially change the situation. Basically the central banks are not as powerful, or as influential, as many seem to think they are, and in particular when globalised money markets mean that traders can leverage funds from one country which is forced to reduce interest rates to meet domestic growth needs (the United States) to supply credit to another where the central bank is busily trying to tighten (India) and where the bottom line in the so-called "carry trade" is set by a Bank of Japan which even during the longest expansion in the country's recent history has proved unable to raise its base interest rate above 0.5% (with few really taking the trouble to ask themselves why this is).

2/. Some of the global imbalances which have been built up over the last half century are now unwinding. In particular some countries which became very poor and very populous in the second half of the 20th century, having now entered their demographic transitions (and see this excellent recent post from Claus for a much fuller exploration of what this really means) are well on the high road to economic development. But due to the specific structure of short term demand as income rises (ie that the marginal propensity of populations in these countries to spend extra income on food) we are seeing important structural changes in some relative prices globally, and the consequences of these changes are quite far reaching.

3/. Almost all countries globally are passing through the Demographic Transition, but countries are at different stages in the process, and in particular some countries have already seen fertility fall sharply below replacement while still remaining economically relatively poor (Eastern Europe and parts of Asia - in particular China, Vietnam and Thailand). This situation really presents us with quite new and complex issues in the context of the rapid rise in the demand for food which the rising living standards which are occuring in these countries is producing. Unlike previous experience in the traditional "demographic dividend" countries, low rural fertility in the above countries means that as young people leave to enter the rapidly growing urban labour market insufficient are left to increase agricultural output at a fast enough rate. Part of the solution to this problem is technological, with increased investment taking place in agriculture, but only part, since as we have seen in developed economies like Spain and the United States which have recently increased their agricultural output, a constant supply of relatively cheap migrant labour has also been necessary. A second solution comes from increasing the relative wages of rural labour (which in its turn of course stimulates technological investment), but then there is no getting away from it, food is going to become relatively more expensive, and this situation is not going to change.

Friday, April 11, 2008

Romania: Current Account Deficit, Labour Shortages and the Risk of Correction

According to the IMF Global Financial Stability report (published this week) parts of Eastern Europe now face a continuing and growing risk of having a "hard landing" as the global financial crisis continues to spread. The fund also drew attention to the possibility of serious spillover problems arising for the Scandinavian, Italian and Austria banks that have lent heavily in the region.

At the heart of the IMF's concerns are the large current account deficits being run in certain CEE countries, deficits which have now reached extreme levels in some cases, running to the tune of 22.9pc in Latvia, 21.4pc in Bulgaria, 16.5pc in Serbia, 16pc in Estonia, 14.5pc in Romania and 13.3pc in Lithuania.

"Eastern Europe has a cluster of countries with current account deficits financed by private debt or portfolio flows, where domestic credit has grown rapidly. A global slowdown, or a sharp drop in capital flows to emerging markets, could force a painful adjustment,"

The IMF said lenders in Eastern Europe had built up "large negative net foreign positions" during the boom, especially in the Baltic states. "Liquidity for these banks has all but dried up and [interest] spreads have widened 500 basis points."

Many of these countries concerned rely on credit from branches of West European and Nordic banks, but these foreign lenders are now themselves having difficulty raising money in the wholesale capital markets.

"A soft landing for the Baltics and south-eastern Europe could be jeopardised if external financing conditions force parent banks to contract credit to the region. Swedish banks, the main suppliers of external funding to the Baltics, could come under pressure,"

So Why Not start With The Trade Situation

Behind the current account deficits lie - more often than not - trade deficits, and in Romania's case the trade deficit widened again in February as rapidly rising wages wages and a consumer lending boom lead citizens to buy more imports even as the currency weakened. And it is here that the heart of the problem exists, since a rapidly accelerating wage price spiral is raising producer prices in a way which will ultimately make domestic industries uncompetitve in their export markets without a strong downward adjustment in the currency, and this downward adjustment will not be possible in Romania's case without considerable pain in the household sector due to the presence of rapidly growing unhedged foreign exchange (mainly euro) loans .

This tendency towards lack of competitiveness is already attested to by Romania's February trade deficit, which totalled 1.46 billion euros ($2.3 billion), compared with 1.4 billion euros in February 2007 and 1.41 billion euros in January, according to data fromthe Bucharest-based National Statistics Institute this week, although it should be noted that Romanian industrial output has been rising, and as a result the deficit is now significantly down from the record highs touched last October and November.

Import consumption has risen in Romania on the back of rapidly rising wages and soaring household borrowing, although again we can note how domestic demand seems to have weakend slightly back in November and December (possibly on the back of interest rate rises at the central bank, and the initial shock of the falling leu), but that imports are now once more starting to pick up pace again, even if at a slightly slower rate than exports (see chart below). So we can say that rising disposable income has in the longer run more than offset the effects of a weaker leu, and imports in February rose at an annual rate of 14.2 percent to 4.24 billion euros.

On the other hand exports were up an even larger 20.3 percent to 2.78 billion euros. This reading confirms the strong picture we have been getting for industrial output, which was up in February by 7.7 % on February 2007 as Romania's new factories steadily ramp up production.

Romania's trade deficit is, as I have been suggesting, the main component of it's current-account deficit, which widened in January to 1.135 billion euros from 972 million euros a year earlier. Fitch Ratings and Standard & Poor's have both lowered their outlooks on Romania's credit rating, citing the continuing current account shortfall as justification.

Foreign Exchange Debt

At the same time part of the recent boom in consumer spending is a result of growing indebtedness. Romanian retail sales growth accelerated in February as rising wages and increased household borrowing gave citizens more disposable income. Sales increased by an annual 23.5 percent in February, compared with 16.6 percent in January, according to the latest data from the Bucharest-based National Statistics Institute. Sales increased 8.3 percent from January.

And a lot of this spending is being financed by borrowing, much of it in euros. According to the latest figures from the National Bank of Romania, in February 2008, non-government credit grew by 2.7 percent in money terms, or 1.9 percent in real terms, from January 2008 reaching a level of RON 158,345.4 million. RON-denominated loans went up month on month by 3.0 percent (2.3 percent in real terms) and foreign currency-denominated loans rose by 2.4 percent when expressed in RON and by 1.6 percent when expressed in EUR. At end-February 2008, non-government credit climbed year-on-year by 65.8 percent, or 53.6 percent in real terms, on the back of a 44.4 percent increase in RON-denominated loans (33.7 percent in real terms) and a 88.9 percent advance in foreign currency-denominated loans expressed in RON (when expressed in EUR, forex loans expanded by 72.1 percent). Forex credit in the household sector was up a whopping 142.3% year on year in money terms.

The possible inflationary consequences of all this borrowing are not far from anyone's mind and especially not from those who are responsible for making policy over at the central bank. Rising wages and economic growth in Romania may spur a "second round" of price increases in coming months, central bank Governor Mugur Isarescu warned only this week.

Romania's economic expansion remains strong, and in fact accelerated in the last quarter of 2007, adding to expectations that the central bank would continue to raise interest rates in an attempt to contain the strong upward movement in inflation which was further fuelled by a strong increase in end of year spending from the Romanian government and the steady household consumption boom. Gross domestic product rose at an annual rate 6.6 percent in the fourth quarter, the fastest pace since the last quarter of 2006, and up from 5.7 percent in the third quarter.

Against this background Romania's inflation has continued to rise and accelerated again in February, reaching the fastest pace in two years and increasing the chances of another interest rate increase, as the government raised natural gas prices and a weaker leu boosted the cost of services. The inflation rate rose to 8 percent, the highest since March of 2006, and up from 7.3 percent in January. Consumer prices rose 0.7 percent in the month, from 0.9 percent in January.

Inflation may continue to suffer further pressure from wage growth, central bank governor Isarescu said at a conference in Bucharest earlier this week , and if we look at what is happening to producer prices - which were up by 13.6% in February - we can see why he is concerned.

Labour Shortage Driven Wage Inflation

``The danger is that a second round of price increases, a so- called inflation spiral, will appear because of higher wages,'' Isarescu said. ``Economic growth is OK, but you have to not push it. I have to accept that politicians address
economic growth because this seems like a simple success.''

Romanian net wage growth, which the central bank says is one of the main drivers of inflation at the present time, slowed somewhat in February when compared with January, but was still very very strong. Net wages rose at an annual 20.5 percent rate, as compared with a 30.7 percent in January, bringing the average net monthly wage to 1,134 lei ($493), according to data from the Bucharest-based National Statistics Institute this week.

Romania's central bank has highlighted wage growth is a main driver of inflation and the main threat to this year's inflation forecast. The central bank increased its main interest rate last month by a half point to 9.5 percent, its fourth consecutive increase. The difficulty is that further increasing the policy rate may simply drive more people to take out euro denominated loans at the cheaper interest rates which are associated with them.

One of the problems monetary policy faces in Romania is the ability of consumers to resort to foreign exchange loans to circumvent it, another is the fact that Romania's labour force is not expanding rapidly enough to feed the economic growth. If we look at the chart below for both economically active and employed population we will see that both of these have been almost stationary since 2002, so what we are seeing here is almost "jobless" growth.

On the other hand Romania's official unemployed population has been trending down, from nearly one million at the start of 2002 to just over 600,000 at the present time.

Only last November Romanian Labor Minister Paul Pacuraru was arguing that Romania needs at least another 300,000 workers to meet current needs and will need more than 1 million within a decade. The labor shortage, Pacuraru said, is caused partly by a migrating workforce and partly by a declining population, and is most acute in construction, and the textile, automobile and food processing industries.

And finance minister, Varujan Vosganian, aims even higher, saying Romania lacks half a million workers."We need more engineers, mechanics and bricklayers," he is quoted by the UK Daily Telegraph as saying "We have a labour deficit of 500,000 employees."

And Vosganian wasn't simply talking about the elites - doctors and IT programmers gone to make their fortune elsewhere, though that would be damaging enough. Romania needs its skilled labourers to return - the people who are going to build up the infrastructure that the country so severely lacks. But when we look at the wage differentials, this idea of a mass return - rather than a steady trickle - would seem to be a forelorn hope to me, whether we are talking about Latvia, Poland, Ukraine or Romania.

The recent settlement in the Dacia strike gives us some indication of just how extensive the labour supply problem now really is in Romania. Basically Employees of Dacia, which is the Romanian carmaking unit of France's Renault today ended an 18-day strike at their Pitesti plant - located about 100 kilometers northwest of Bucharest - after accepting a higher pay offer.

The 13,000 employees returned to work this afternoon after accepting a monthly pay increase of 360 lei ($158). Dacia employees started the strike on March 24, halting production of 1,300 cars a day from the factory, to back demands of a wage increase of 550 lei a month each. This pay increase brings the average wage of a Dacia employee to 2,256 lei a month before tax. The company had originally offered a raise of 155 lei per month per employee. Dacia's sales increased 17 percent last year to 230,000 vehicles as it boosted exports to France and Germany and Romanian wages and lending soared, giving citizens more purchasing power. Average net wages increased an annual 20.5 percent in February.

Dacia, which has more than a 30 percent share of Romania's car market and exports Logan sedans worldwide, produces more than 1,300 vehicles per working day at its Pitesti factory. Dacia is also a main Romanian exporter, with exports rising 44 percent last year from 2006 to more than 128,000 cars, the company said.

So the simple issue is, what is now the normal capacity neutral growth rate for Romania at this point (remember this rate will tend to get gradually less as the population continues to decline)? That is, what is the annual growth rate which Romania is capable of without seeing the sort of inflation we are seeing at the moment? Noone really knows, but it is obviously well below the rate Romania is currently growing at.

This tendency towards "labour market pinch" is in part produced by Romania's long term low fertility - which makes sustained growth in the 6% range over any lengthy period of time look frankly virtually impossible - and by strong out-migration in recent years - in particular to Italy and Spain where there are a combined total of over 1 million Romanians (out of a population of around 20 million) now living and working.

The Double Edged Prong Of Inflation and Global Credit Risk

Romania needs to cut its inflation rate, and rapidly. In particular it needs to be down to 3 percent by the end of 2010 or -among other issues - it will risk missing its target of adopting the euro in 2014, according to the latest statements by central bank governor Isarescu. Isarescu also suggested that he found the leu's current exchange rate "more sustainable'" than the level the leu was tradinga t in early 2007. The leu has dropped 9 percent against the euro in the past year and was trading at 3.6566 to the euro as of 9:30 a.m. in Bucharest.

As the IMF note in their report, awareness of higher risks in the CEE countries has been rising in recent months, and this rising awareness has been been reflected in the performance of bank stocks exposed to the region, in Credit Default Swap spreads, and in the performance of the Romanian leu (see chart below) given that the leu is the only floating currency with a liquid forward market among the group of eastern European countries with large external imbalances. As we have seen it has depreciated substantially since July 2007, as investors have been expressing their negative views on the region as whole The stocks of Swedish banks exposed to the Baltics have underperformed other Nordic bank shares (and here) partly owing to significant short-selling and CDS spreads on sovereign debt have surged since August 2007, as investor demand for credit protection has pushed up prices. The interesting point to observe is how this is now all moving in tandem.

In fact the IMF specifically notes how in Bulgaria and Romania, tighter credit risk controls by parent banks have not been effective in slowing aggregate credit growth, as new entrants, notably Greek and Portuguese banks, have sought to expand market share. Since Bulgaria and Romania only recently joined the European Union, they are still seen by many banks as offering attractive growth opportunities. However, there is a danger that local banks may underestimate the deterioration in the quality of loan portfolios that often accompanies rapid credit growth.

Banks active in Eastern Europe also face risks on the asset side of their balance sheets. House prices have soared in tandem with domestic credit growth, and the credit portfolios of banks in emerging Europe have increasingly become exposed to the real estate sector. In Estonia and Latvia, house prices have now started to fall, which has led banks to curtail lending to many construction projects, while more developers have resorted to preselling apartments - thus sending the credit risk back on round to the banks via the circuitous route of household default risk - in order to receive financing up front for them. Banks have not experienced a significant increase in loan losses so far, and they have centralized and strengthened risk management in a manner similar to mature market banks. Internal risk controls could force a sharp reduction in credit at some point simply to protect bank capital, if asset quality is thought to be about to deteriorate sharply. So a win-win dynamic could rapidly turn into a lose-lose one under the right circumstances. True the ratio of household credit to GDP is considerably higher in Estonia and Latvia (above 40 percent in 2007), than it is in Romania (18 percent in 2007), but credit dependence is growing rapidly, and as we have been seeing there are special difficulties in Romania which make sustainable and inflation free 3 per cent plus growth structurally difficult over any lengthy period of time, and this reality should, at the very least, be making people rather nervous at this point.

By Way of Conclusion

So what gets to happen next in Romania? At this point this is very hard to say. Emerging markets have - as the IMF argues - so far proved broadly pretty resilient to the global financial turmoil. Improved fundamentals, abundant reserves, and strong growth have all helped to sustain flows into emerging market assets. However, important macroeconomic vulnerabilities do exist - especially in the context of quality labour supply and inflation free growth potential, coupled with the dangers of a current-account-deficit/capital-flows unwaind - in a number of the CEE countries which make them rather susceptible to any significant deterioration in the external environment (see chart below).

(Please Click On Imgage For Better Viewing)

Eastern Europe contains a hard core of countries with current account deficits financed by private debt or portfolio flows, and where domestic credit has grown rapidly. A global slowdown, or a sharp drop in capital flows to emerging markets, could lead to a very painful adjustment process in those countries. The IMF identify - as follows - a number of distinct risks to CEE economies arising from the current turmoil.

First, mature market banks may pare back funding to their local subsidiaries, particularly in circumstances where external imbalances are large.

Second, balance sheet contraction by global financial institutions may reduce funding for investments by hedge funds and other institutions, raising their dollar funding costs, and inducing fi nancial stress within some emerging markets.

Third, emerging market corporate credit risks may continue to increase. Emerging market corporate debt spreads have already moved ou about as much as those of similarly rated credits in mature markets.

Fourth, emerging market financial institutions may yet prove vulnerable to financial contagion through exposure to subprime or other structured credit products.

Fifth, a spike in exchange rate volatility could slow or reverse fl ows into emerging market fixed-income assets, leading to higher funding costs. Negative terms-of-trade shocks could raise diffi culties for emerging markets in Latin America and elsewhere that have benefi ted from the commodity price boom. More broadly, a global slowdown could affect fl ows into emerging market assets.

If we add to this list the fact that a number of Eastern European economies are now visibly overheating while others seem getting near to the point of doing so, then the risk and the dangers of the potential outcome seem plain enough to see.

Italy's Economy Going Into The Election

As Italians head to the polls this weekend in order to pick what will be their 62nd government in 65 years (in an election which is being held three years early to boot, due to the collapse of Romano Prodi's outgoing administration) one odd detail seems to stand out and sum up the multitude of political and economic woes which confront Italy at the present time: we still don't have economic growth figures for the last quarter of 2007. Now this situation may well be an entirely fortuitous one - Italy's national statistics office ISTAT are in the process of introducing a new methodology to bring their data into line with current EU standards as employed in other countries (Italy yet one more time is at the end of the line here, but let's not get bogged down on this detail) - but there does seem to be something deeply symbolic about all this, especially since Italy may well currently be in recession, and may well be the first eurozone country to have fallen into recession since the global financial turmoil of August 2007.

Perhaps the other salient detail on this election weekend is the news this (Saturday) morning that "national champion" airline Alitalia is near to collapse and may have its license to fly revoked, at least this is the view of Vito Riggio, president of Italy's civil aviation authority, as reported in Corriere della Sera.

"If something isn't done soon, everyone must realize that Alitalia is on its last legs.... The authority will have no choice but to revoke the airline's license ``in two, maximum three weeks if it can't show it can find cash to stay in business"
And as if to add insult to injury, only this week the IMF revised down yet one more their 2008 forecast for Italian GDP growth, on this occasion to a mere 0.3% - and (as we will see below) a steadily accumulating body of data now clearly suggest that Italy is probably already in recession, and may well have entered recession sometime during the last quarter of 2007. If confirmed this will mean that Italy will have been in and out of four recessions in last five years. So perhaps the real question we should be asking ourselves is not be whether Italy is in a recession, but when in fact she enter it, and even more to the point, when will she leave?

``Italy and its economy are like the Titanic hitting the iceberg,'' said Gianni De Michelis, deputy prime minister in 1988 and 1989. ``It's gotten to this stage after years of negligent governments on both sides. Berlusconi or Veltroni? It makes no difference.''

It should be plain from the above long term growth chart that the problems Italy is facing are not mere conjunctural (cyclical) ones. Deep structural processes are now obviously at work, and Italy is now in danger of spending more time in rcession than she actually spends out of one, a position which has some similarities with the Japanese lost decade - the so called Heisei recession - of the late 1990s and early 2000s. And this comparison may not be entirely accidental since, as we shall see below, Japan and Italy are two of the planets three (along with Germany) oldest societies.

But first let's take a look at some of the evidence that Italy may well now be in recession.

Retail Sales

Italian retail sales fell through the floor in March - at least according to the Bloomberg NTC Purchasing Managers Index - with sales being registered as falling at the fastest pace in four years. The seasonally adjusted index of retail sales declined to 36.4 from 43.8 in February, the lowest rating shown by any country since the survey began in January 2004. The reading on this particular index has now been below 50, the level that signals a contraction in sales, since February 2007.

In January (which is the latest month for which we have data) retail sales in Italy were up year on year by 1% according to data from the National Statistics Office (ISTAT). While the values on the two measures are a little different, with ISTAT figures being notably a little more volatile, the general downward trend in the rate of new activity since mid 2006 is still noteable in the chart.

A further indication about the current state of mind of the Italian consumer can be found in Italy's new car sales, which fell for a third straight month in March - down 18.76 percent - year on year. Sales of Fiat's three brands suffered an even harder fall of 20.6 percent. Registrations of new car sales totalled 212,326 in March against 261,370 for the same period last year. Those for cars of the three brands belonging to the Fiat group totalled 65,594 against 82,649 in March 2007. Fiat's share of registrations in what is its home market was 30.89 percent.

If we look at car sales across the first quarter taken as a whole then we find the total number of sales registered with the transport ministry was - at 663,532 - down 10.01 percent on the first quarter of 2007. This seems to suggest that the situation deteriorated dramatically between January and March, a finding which is entirely consistent with the shocking retail PMI reading for March.

Household spending, which makes up two-thirds of Italy's economy, was slowing throughout 2007, only growing very slightly (by 0.2 percent) between the second and third quarters, a rate which was down when compared with the 0.5 percent rise achieved in the second quarter over the fisrt, or the 0.7% one in the first quarter over the fourth quarter of 2006.

Indeed what we neem to note is that Italian domestic consumption, despite the considerable increase in the working population via immigration and the low levels of unemployment registered recently, is now congenitally weak, and only twice since the start of 2003 - during the rather exceptional Q1 and Q2 2007 - has the rate of increased broken through the 2% year on year threshold.

So Italian household consumption has remained unmovingly weak over a number of years now, and this weaknes rather took me by surprise, I must admit, when I first became aware of it, since it so closely mirrors what we have been seeing in Germany and Japan, where again, and despite extensive labour market reforms and extensive job creation domestic consumers have not been able to drive the economies. Due to the similarity in the structural components here between Germany, Japan and Italy (with Italy's weaker export performance being the only real distinguishing feature, indeed you might almost call Italy Germany and Japan without the export prowess) Claus Vistesen and I are arguing that the whole phenomenon is ageing related, since these three societies - with median population ages pushing the 43 mark - are now the oldest on the planet.

Industrial Output

If we now turn to Italian industrial output we find that this declined in February - the most recent month for which we have data from ISTAT - as the worsening economic outlook reduced demand for manufactured products. Production dropped 0.2 percent after rising a revised 1.2 percent in January. The seasonally and working day adjusted output index dropped back to 97.8 from 98.3 in January.

Year on year (and working day corrected) output was down 0.8% over February 2007. Production of Italian consumer goods fell 2.6 percent from January as the output of durable goods like refrigerators declined 0.6 percent with non-durable goods contracting 2.6 percent. The only gain came in energy related goods, which rose 0.5 percent.

Part of the decline in output may have been caused by the plunge in car production, which fell 24 percent from a year earlier on a non-adjusted basis. Istat did not give car output figures comparing February with January. Production of all vehicles - including trucks and busses - declined 3.2 percent from a year earlier on a non-adjusted basis.

If we look at the purchasing managers index and observe the chart (below) we can find the same general picture with the rate of expansion slowing from mid summer, and the index actually registering month on month contraction in March (49.4) for the first time in nearly three years, suggesting that output slowed to stagnation as exports decline.

"The slowdown largely reflected a fall in new orders from both domestic and foreign markets. Operating conditions were further worsened by the fastest rate of cost inflation for 20 months," NTC/ADACI said. NTC Research chief economist Chris Williamson said the figures were consistent with stagnation in the first quarter and added there could be a worsening in the second quarter given the fall in new orders.


Italy's service sector also seems to have contracted in March - for the fourth consecutive month - though the rate of contraction did drop back from February's record rate, as employment fell and input prices rose at their fastest pace on record, according to the latest NTC/ADACI survey. The NTC Research Purchasing Managers Index, which covers companies ranging from hotels to insurance brokers, rose to 48.8 from February's 47.2. Despite the recovery from February's all-time low, March's reading remained below the 50 divide between growth and contraction for the fourth consecutive month.

If we add all of this - retail sales, industrial output, services activity - together it is hard not to draw the conclusion that Italy is now in recession.

"These figures, coupled with the manufacturing PMI, suggest Italy's economy has started to contract," said Chris Williamson, chief economist at NTC Research which compiles the data. "It's hard to see any silver lining and it doesn't seem the worst is over by any means," he said, forecasting Italian gross domestic product fell 0.1 percent in the first quarter.

Sentiment Indexes

If we now turn to the sentiment indexes, a similar picture emerges. The European Commission recently reported its eurozone “economic sentiment” indicator for March, with the composite number for the whole region bouncing back a little from the February reading which its lowest level since December 2005.

The indicator, which gauges optimism across all economic sectors and is regarded as a good guide to likely future trends, was back up to 102 after falling to 100.1 in February from 101.7 in January. However the picture is a mixed one (see chart below), with Germany for the time being holding reasonably stable (and climbing back to 104 from 103.7 in February), France also holding up fairly well at 105.6 (up from 105.2 in February), while Ireland continues to hover near the brink, Italy continues its steady downward path, and Spain heads straight off the map. (the March reading in Spain was 83.9 which was down from 87.5 in February). I suppose in the Spanish case it is now simply a question of how low can you go before you hit bottom.

Maybe for Italy at least there some consolation here, since bad as they are, they are far from being the worst case scenario at this point. This, however, is precious little in the way of consolation. And especially not when we start to think about all those government debt financing issues which are looming just round the next corner.

At the same time Italian business confidence declined to its lowest level in two and a half years in March as slowing economic growth and the euro's appreciation continued to weigh on orders and optimism. The Isae Institute's business confidence index fell to 89, the lowest since August 2005, from a revised 89.6 in February, according to the Rome-based research centre earlier in the month.

Worthy of note was also the fact that a sub-index measuring Italian manufacturers' total orders fell to minus 16 from minus 13. Exporters are currently pretty pessimistic about their short-term sales outlook, with the relevant sub-component falling to 5 from 9 last month, according to a recent quarterly survey of exporters.

``The fall in confidence is due above all to the contraction in orders,'' Isae
said. ``In the first quarter of 2008, both current exports and the outlook for
exports worsened.''

Italian consumer confidence falso fell in March - in this case to its lowest level in nearly four years, as rising prices and slowing economic growth increased pessimism among growing numbers of Italians. The Rome-based Isae Institute's index, based on a survey of 2,000 families, fell to 99 from a revised 102.8 in February. This reading is the lowest since May 2004.

Italians have been steadily cutting back on their spending, which makes up two-thirds of the economy, as the continuing rise in the cost of food and transportation reduces their disposable income. ISAE is currently predicting that the Italian economy will grow by as little as 0.5 percent this year, the slowest pace since 2003.

Again some of the details here are really quite striking, since the sub component concerning optimism about the current economic situation fell to a 14-year low of minus 132 from minus 118 in February, and the number of Italians who are "very concerned'' about rising prices is at a four-year high.

Obviously overhanging the whole economic climate is the current election campaign, which was triggered by the collapse of Prime Minister Romano Prodi's government in January after 20 months in power. Both leading candidates, two-time premier Silvio Berlusconi and former Rome Mayor Walter Veltroni, are promising tax cuts to help revive growth, although given the large fiscal constraints that this growth slowdown will present, it is far from clear where any of these will come from and more than likely most consumers interviewed were only too well aware of this when forming their assessment.

Italian Inflation

On the other hand the news on the inflation front is not good at all. According to the latest ISTAT data Italy's inflation rate rose in March to the highest level in more than 11 years, driven by gains in energy prices and a surge in the cost of food and housing. Consumer prices calculated by European Union's harmonised index rose 3.6 percent from March 2007, an increase on February's rate of l3.1 percent. The February reading had previously been the highest rate since the index was created in January 1997.

Consumer prices rose 1.6 percent in March from February, which is a very rapid rate indeed (annualised 18%). The rate of price increases has clearly accelerated and Italy - which given the very low (or even negative) rate of economic growth which exists at this point - could be said to be suffering from some variant of stagflation. This will not make it at all easy for the ECB to bring any kind of early reflief in the form of rate cuts (which could be just as important for their impact on the current high value of the euro which is crimping Italian exports, as for any easing of lending conditions) in the near future.

Employment and Unemployment

The one bright star in the Italian economic firmament in recent months has been employment. The Italian unemployment rate has been steadily falling since the last quarter of 2004, and in the last quarter of 2007 it stood at 6 percent, its lowest level since 1993.

However these record-low unemployment rates in Italy mask significant regional disparities in joblessness. The jobless rate in Italy's industrial north was 3.4 percent in the fourth quarter, compared with almost 11 percent in the mezzogiorno (south of the country).

Italian unemployment has in fact declined steadily since 1999 after the introduction of changes in labour market regulations which effectively made it easier for companies to hire part-time and temporary workers who don't enjoy the same benefits and job security as full-time staff and can be more easily fired when financial constraints force cuts. This flexibility in the ease of hiring and firing is also reflected in the data, since the number of full-time workers with temporary contracts fell year on year in the last quarter of 2007 for the first time in at least three years, indicating that as the Italian economy slowed these were the first workers to go.

Part time working has also grown steadily since the reform, and nearly 1 in 4 jobs in Italy are now either part time or temporary.

And growth in temporary and part time working has been especially pronounced among the over 35 age group. Unfortunately ISTAT don't provide detailed enough data here, but I think it would be reasonable enough to assume that a significant share of these workers are over 50, since stable employment participation rates in the 35 to 50 age group are traditionally high, so there is not a big pool of workers waiting around to be "sucked into" employment during times of economic expansion.

Moreover, after many years of very low fertility, fewer and fewer young Italians are now joining the workforce to replace the older Italians who are retiring, and their places are now being taken by a steady stream of newly arrived immigrants. In fact two-thirds of the annual increase of 308,000 new workers in the fourth quarter were immigrants, with the other third being effectively accounted for by an increase in employment rates in the 55 to 64 age group. So yet one more time we find a significant difference between what has been going on in Italy and comparable countires experiencing rapid population ageing - Japan and Germany - since while all three countries have leveraged labour reforms to increase job creation, and in all three economies unemployment has been falling steadily, in Germany and Japan this increased employment has been achieved by substantial icreases in the over 55 age group employment participation rates (for developments in Japan see this post here, and for Germany see this one), in Italy - given the ongoing failure to reach agreement on substantial increases in the retirement age and the inability to convince the general population that the problem is an urgent one - a very large share of the new employment has gone to immigrants, who are effectively working to pay a significant chunk of the pensions bill being run up by all of those who are still retiring at 58.

Last November Prodi finally managed to get the support of Italy's labour unions for the 2008 budget by accepting a much more gradual pace of increase in Italy's pension and retirement age as a trade off. The agreement he reached involved a staggered increase in the minimum retirement age, which at that point was set at 57. The change in fact involved supplanting (or going back on) a previously agreed reform law - one which would have boosted the retirement age to 60 from as early as January 2008 - and an effective slowing down of the reform process. The law which was put aside was agreed to in 2004, by one of Silvio Berlusconi's governments, and the decision taken then had been to raise the minimum retirement age— from 57 to 60 - as of January 2008. Under the new Prodi plan the retirement age was raised by one year, to 58, in 2008. In July 2009 the retirement age will again go up, this time to 60 for those with 35 years of contributions, or remain the same for those workers who can muster 36 years of pension payments. From 2011, the retirement age for everyone will rise to 60, and then to 61 by 2013.

This decision, apart from being an astonishing one for outside observers, raises a number of important issues, especially since the ageing population problem is one which affects Italy in a very important way. Male life expectancy in Italy is now fast approaching 80, and is among the highest in the EU. At the same time Italy currently has the third-lowest birth rate in the EU (TFR around 1.3). Without raising the retirement age, contributions simply won't keep pace with pension payments over the coming years, even assuming there is no ageing impact on the overall economic growth rate, which as we are seeing is far from clear.

Of course doing things like this is totally unsustainable. Italy undoubtedly needs migrant labour, but as a complement to, and not a replacement for, a very substantial and swift increase in the retirement age and in employment participation rates among the over 60s.

The regional disequilibrium in Italy also seems to be becoming quite important again (just like the East-West one in Germany, and Tokyo vs the rest one in Japan). While the national participation rate for the 55 to 64 age group went up from 28.9% in Q1 2004 to 33% in Q3 2007, in the mezzogiorno it has gone up from 31.8 to 35.3 over the samer period, so the South is keeping pace here, but if we look at the 65 plus group, while participation has gone from 3.4% to 4% nationally over the same period, in the mezzogiorno it has gone DOWN from 2.4 to 2.1%. The 15 to 64 participation rate also dropped from 54.1 to 52.5 over the period in the mezzogiorno while in the North it went up from 67.8 to 69.2 %. And this situation is reflected in the relative job creation performance between the North and the South.

Basically, given the very strong fiscal pressure which is about to come in Italy, and the danger of a possible sovereign default at some point, if nothing is done to correct the underlying weak national growth trajectory, Italy can be almost literally torn apart by this type of disequilibrium, especially given that it is reinforced by the unequal distribution of migrants (see chart below, the migrants are overwhelmingly concentrated in the North and North East of the country). We thus have an ongoing polarisation of wealth, employment and people, and we really aren't giving sufficient consideration to the longer term political implications of the underlying economo-demographic process.

If you look at the chart below (which is, I admit, a slightly illegitimate one - but only slightly so - since I have derived it by subtracting the number of foreign workers and the number of workers from 55 to 64 from total employment, and some - even if very few for their age profile - migrant workers are in the 55 to 64 age group) we can see that the number of under 55 year old Italians in the workforce has been virtually stationary during the last two years, years of comparatively strong economic growth (in Italian terms) and record low unemployment. I think it is very easy to see some sort of ageing population effect in all this.

So, where does that leave us? Well with a not especially strong underlying labour market dynamic I would say. Employment is being created, but not specifically in high value work. New employment is, as I say, increasingly of low skilled immigrant workers, and part time or temporary workers in the over 50 (and indeed over 60) age group. And all of this despite the evident progress that has been made in bringing down unemployment. Basically the Italian economy is creating employment, but it isn't creating productivity, and it isn't creation strong expansions in consumption. And again, if you take a long, hard and cold look at these numbers I think it isn't too hard to see some of the reasons which help to explain why Italy is suffering from the rather weak consumption and low productivity growth.

Italy's Trade Deficit

Given that Italian domestic consumption remains weak, exports - and with them the value of the euro - take on a special significance. As opposed to other ageing and export dependent economies like Germany and Japan, Italy runs both a trade and a current account deficit. In 2007 the trade deficit was running at a rate of 9.5 billion euros, although this was down substantially from the record deficit of 20.5 billion euros in 2006. The improvement in 2007 was largely due to an improvement in export performance, since Italian exports were up by 8% while imports were only up by 4.4% during the year. Italy has been running a current account deficit since 2000, and evidently a significant part of the instability in Italian economic growth since the turn of the century is attributable to this single detail (given that Italy is an export dependent economy). If we look at the chart below it is evident that as the current account situation has deteriorated economic growth has become more and more fragile. This is not simply because Italy has not reformed sufficiently and has become uncompetitive (the standard explanation, which is of course the case), but because in the context of a rapidly ageing population it is the lack of "gusto" in domestic consumption which makes the whole position so unstable (the part the standard explanation normally misses, and what separates Italy from other - younger - current account deficit running economies like Spain, which is surely hardly any more "competitive" at the export level, indeed arguably it is a lot less so, as we may be about to see as the housing boom steadily disintegrates).

In general Italy maintains a trade surplus with the other countries in the European Union (5.7 billion euros in 2007, up from 210 million in 2006), and the lions share of the trade deficit comes from commerce with the rest of the world, of which of course energy forms an important part. The deficit is important, since with the continuing very sub-par growth in domestic consumption, economic growth - and with it the sustainability of public finances - very much depends on export performance, and indeed Italy will only be able to achieve stable economic growth by running a sustained and sizeable trade suplus.

In fact Italy narrowed its trade deficit with non-European Union countries in February, boosted by exports of refined petrol and machinery and a slight improvement in exports to the U.S. according to the most recent data from Istat. Italy's trade deficit with non-E.U. countries was 1.33 billion euros in February, which compared with a 1.74 billion deficit in February 2007. Exports to countries outside the E.U. thus rose 17.7% year on year to 12.88 billion euros, while imports from non-E.U. countries increased 12% to 14.21 billion euros.

Istat said the improvement was driven in large part by exports of refined petrol products and machinery and mechanical appliances, which rose 67.8% and 27.8% respectively.

Exports to the U.S. rose 10%, while imports from the U.S. increased 2.4%. Imports from the OPEC countries, which account for 9.3% of Italy's total imports, rose 33% on the year. Imports from China, which alone now constitute nearly 6% of the import total, rose 8.4%, while exports to China were up 20.1%. The narrowing of Italy's trade deficit with non-E.U. countries in February offers some support to the view that exports may well rebound modestly in the first quarter of the 2008, offering a little support to what is otherwise bound to be a very weak GDP growth number.

In January, which is the last month for which we have total trade data, Italy had a trade deficit of 4.22 billion euros, compared with a deficit of 3.69 billion euros a year earlier. Exports rose 12% year on year and 4.9% month on month, while imports rose 12.3% year on year and 1.7% month on month.

Italy's trade surplus with other European Union countries slowed in January, to EUR125 million euros, which compared with a surplus of 619 million euros in January 2007, as exports slid 1.3% on the month, but rose 8% on the year. Imports rose 11.8% on the year and 0.8% on the month.

In general it is the persistent inability of Italy's export sector to compensate for the lack of strong internal demand growth which makes the path of Italian GDP so unstable.

Is Italy In Recession?

Italy's economy will expand in 2008 at the slowest pace in five years as "external shocks" such as record oil prices and the strong euro impact consumers and businesses, according to the most recent report from Italy's leading ISAE research institute.. The institute now predict that the Italian economy will grow by only 0.5 percent this year. That's down from their October forecast of 1.4 percent and if realised will be the weakest Italian growth rate since 2003.

Italy's Finance Ministry, on the other hand, still expect growth of 0.6 percent this year, the European Commission expect a rate of 0.7%, while Confindustria, Italy's largest employers' group, has cut its forecast to 0 percent.

The International Monetary Fund cut its Italian growth forecast to 0.3 percent for this year and the next, making Italy the worst-performing economy among the Group of Seven nations and the 15 countries sharing the euro.

Italy is thus topping lists worldwide as the developed economy in the worst shape. The country came last in terms of labor productivity - a key measure of economic growth and competitiveness - in a recent inter-country comparison carried out by the 30-member Organization for Economic Cooperation and Development. No other developed economy has been through three recessions in five years (now heading into its fourth) and the country is coming to look more and more like the Japan of the "lost decade" - even down to the huge increase in the government debt to GDP ratio. It is clear that Italy is now saddled with a whole plethora of economic problems that are holding it back, not the least of them its loss of overall competitiveness.

Watch Out, Here Come The Ratings Agencies

Whoever wins the election, Italy's new government's ability to stimulate the economy with tax cuts (or any sort of fiscal policy) is certainly going to be limited, since the Italian government has to finance and struggle to reduce what is currently the world's second-largest sovereign debt to GDP ratio. Italy's debt did fall back slightly in 2007 - to 104 percent of GDP from 106.5 percent in 2006 - but it is still huge, and of course 2007 was a remarkably good year, while we may now be about to have a remarkably bad one (or two, or more....). Again interest on the national debt currently runs at some 70 billion euros ($109 billion) a year, or about 1,200 euros for each Italian, and any serious slippage in fiscal "clean up" is going to be closely watch by the financial markets, where, it will be remembered, the difference in yield between Italian 10-year bonds and the benchmark German bunds increased to the most in almost a decade last month. The spread between German and Italian bonds widened to 52 basis points in mid March, the most since October 1998, when it was as by much as 61 basis points. Any repetitions of this incident will surely cost the Italian government dear, since spending programmes - like Italy's pension system that already eats up a full 15 percent of GDP - will almost certainly become more expensive to fund, leading to cuts in other - less protected and less structural - areas.

The deficit itself also fell back last year to 1.9 percent of gross domestic product, its lowest level since 2000. That is about half the 2006 deficit of 3.4 percent and - for the time being - within the EU ceiling of 3 percent. But what this deficit reduction process means is that Italian fiscal policy will also be restrictive, tightening the economy even as it falls back into yet another recession.

Nor will monetary policy be much help - at least in the short term - since Italy's prospects of obtaining cheaper interest rates to aid recovery are currently being frustrated by a European Central Bank anti-inflation policy that has kept borrowing costs at a six-year high of 4 percent even as several important eurozone economies have been slowing, and as the euro has surged - not coincidentally - to ever greater "highs" against the dollar. The single currency has risen by 11 percent over the past six months against the dollar and has hit a record 1.5913 dollars only this week, a development which lead European Union Economic Policy Commissioner Jaoquin Almunia to issue an explicit warning about currency valuations getting out of line with economic fundamentals.

Looking forward Italy's budget deficit is expected by ISAE to rise to 2.7 percent of gross domestic product this year. This is more than the 2.6 percent formerly predicted, (the Finance Ministry currently predict a deficit of 2.4 percent of GDP in 2008, again up from the 2.2 percent originally predicted) though all of this is still within the European Union ceiling of 3 percent. The difficulty is that this position may be subject to slippage, as revenue falls, and - if unemployment were to seriously rise - payments go up. So one of the most important consequences of the current weak growth is that it is likely to put increasing pressure on the budget deficit.

Italian tax receipts were higher than expected in the first quarter of 2008, the Italian Finance Ministry announced last week. Overall tax receipts increased 5.6% to 60.1 billion euro over the quarter, up from 56.9 billion euro in the first quarter of 2007. Overall receipts in March rose 10.1% to 29.9 billion euro from 27.1 billion euro in March 2007. Two-thirds of the increase in tax receipts in the first quarter are due to higher income taxes, according to the ministry's data. However, receipts from value-added tax rose only 0.9% on the year in March, reflecting the weaking climate in both consumer confidence and spending.
"These results are well above the trend projected by all the main macroeconomic variables," the ministry said.

The ministry noted that the 2008 budget forecast a net reduction in tax receipts of around 3 billion euro, so that the excess in the first quarter pointed to the possibility of "extra" income for the state over the course of the year.

Silvio Berlusconi and Walter Veltroni in fact have broadly similar economic programs, offering tax cuts and more public works spending as formulas to revive a stagnant economy. But both have failed to convince either economists or many Italian voters that they can afford to keep their promises.

Italy's ailing economy will limit room to maneuver on policy for its next government, as shown by similarities in the main political programs, a senior credit officer at Moody's Investors Service said on Friday. Alexander Kockerbeck said the targets set by the two main candidates in their programs pointed in the right direction, but the problem would be the next government's ability to achieve them.

Berlusconi pledges tax cuts on everything from income to property and plans to boost spending on costly infrastructure projects such as the world's longest bridge, linking Sicily to the mainland. Veltroni is offering similar tax cuts and wants to boost spending on roads and railways. Their plans are by no means cheap. Berlusconi would need some 63 billion euros to fund his manifesto promises, compared with the 58.3 billion euros for Veltroni, according to economists at Intesa Sanpaolo. To finance their plans, both would need to save money elsewhere and improve tax collection in a country where evasion is estimated to account for a minimum of 15 percent of gross domestic product.

Berlusconi has promised unspecified spending cuts and says he will sell state assets to pay down the debt which he himself accumulated. Veltroni calls for cutting spending by 0.5 percent of gross domestic product during his first year and by 1 percentage point a year after that, without specifying how he would do this.

Apart from the exceptional effort made in 2007, recent Italian governments have not done especially well in cutting state spending 8to put it mildly), which rose substantially during the last Berlusconi administration between 2000 and 2005, and now remains steady at around 40 percent of Italy's GDP. And the situation is a delicate one, since even if both candidates continue Prodi's clampdown on tax dodgers, fiscal revenue will inevitably slow as growth slackens.

Both candidates say they would like to fund special programs, such as increased minimum pension benefits, with the extra income the hope to obtain from clamping down on tax evasion, but they really may be jumping the gun somewhat here, and it will be interesting to see whether they are so imaginative and so enthusiastic when it actually comes to collecting the money in the first place. I would say downside risk for slippage on the fiscal deficit front is strong at this point, and especially if the Berlusconi coalition win the elections.

Silvio Berlusconi, tends to brush aside such concerns, and seems to see the issue as already a "done deal", since he is busy dreaming up ways to spend the extra income, without - it seems to me - taking due account of how the economic slowdown may impact both income and expenditure. "We will use that treasure to abolish this tax that has no reason to exist" he said on the "Matrix" television programende, refering to his "surprise" last minute, rabbit-out-of-the-hat proposal to eliminate a tax on car and motorcycle registration - at a cost of 4 billion euros - a cost which is, of course to be met by tapping the surplus - "that treasure" - always assuming that at the end of the day it exists.

``We hope they would reduce expenditure in public administration and, more importantly in the long term, cut pension spending before contemplating tax cuts,'' S&P's credit analyst Trevor Cullinan said in a telephone interview from London. ``That doesn't look likely.''

The pledge on the part of both candidates to cut Italy's public debt while at the same time easing tax pressure isn't cutting that much ice over at the credit rating agencies however. "I looked at the two programs and they seemed to confirm that margins for maneuver are limited," said Alexander Kockerbeck, senior credit officer at Moody's. Kockerbeck indicated that the stabilization in the level of the country's public debt warranted the retention of the stable outlook for the time being, but but he was quick to add that it was still too early to say whether the trend was under control in the medium term. "The latest positive data on debt and deficit are neutral in terms of their impact on the ratings because we saw them more as cyclical than structural."

To understand just why analysts like Trevor Cullinan and Alexander Kockerbeck may be worried one need look no further than to Silvio Berlusconi's proposed solution to the Alitalia crisis, which involves finding the money to float a rescue, rather than putting the squeeze on the Unions to come to terms with air France. Berlusconi has repeatedly denounced the Air France bid and said he personally would seek an Italian buyer. Veltroni has accused Berlusconi of "interfering" and called on unions and Air France to resume negotiations to save the airline and jobs.

``We cannot give up our flagship carrier,'' Berlusconi said in Rome during a campaign speech. ``I renew my appeal for Italian businessmen'' to join together to buy Alitalia, he said.

And while Alitalia was busy amassing more than 3 billion euros in losses over the past decade, Italy's overall competitiveness was slipping to 46th in the World Economic Forum's 2007-2008 ranking, putting it behind free enterprise stallwarts like Latvia, South Africa and Bahrain. In the 15 country eurozone Italy ranks only above Greece. And much of the slide in both state indebtedness and loss of competitiveness came precisely during Berlusconi's second period as prime minister between 2001 and 2006.

Unicredit economist Marco Valli is widely quoted as saying that he has not tried to do detailed costing on the two programmes because some measures will certainly not be implemented, while the final days of the campaign is seeing a 'crescendo' of promises. However, even without detailed calculations, he argues that it does seem 'possible' that Berlusconi's PDL's plans will breach the EU's 3 percent deficit limit, especially if they do not continue to be so vigourous in the fight against tax evasion (remember, Berlusconi described the methods being used by the outgoing Prodi government as "brutal").

Dresdner Kleinwort have also expressed the view that the new government will run into severe difficulties if it attempts to implement either of the groups' tax cuts. "Indeed, Italy agreed with the EU to reach a budget balance in 2011. With an estimated deficit of 2.4 percent in 2008 and 2.1 percent in 2009, the new government should pursue a tough fiscal policy" it said in a statement.

The prospect of rising debt fuels the risk to Italy's credit rating, ratings companies say. Standard & Poor's and Fitch Ratings slashed Italy's creditworthiness in October 2006, less than six months after the last election. S&P also cut the rating in July 2004, during Berlusconi's tenure. Fitch rates Italy's long-term debt AA-, while S&P gives it A+. Italy's debt is rated 'Aa2' with a stable outlook by Moody's.

And the issue with the ratings agencies is no mean one, as the ECB made clear back in November 2005, when they took the decision not to accept government paper (bonds) in the future from any country which has not maintained at least an A- rating from one or more of the principal debt assesment agencies. So, to end up where we began, rather than Gianni de Michaelis' analogy of the Titanic and the Iceberg, could this recession actually be the occasion that the Italian economy actually lets itself slide so far down the slippery slope that it proves well nigh impossible - in the conetxt of it's sovereign debt dynamics - to claw its way back up again. At this point it is hard to see, but this is not a danger, or a possibility, that any of us should be taking lightly.

Or perhaps Berlusconi has another plan up his sleeve to get Italy out of the mess:

"Ronaldinho only wants Milan", said Silvio Berlusconi. The President of AC Milan, in Savona for an election rally, said: "We are trying our best to bring him to Milan, Ronaldinho said he would not be in any team if not in that of the world champions, that is us. He would come here also because there are so many of his fellow Brazilians and he knows that at Milan we treat everybody very well."

Well I think it only remains for me to express the hope that his plan to keep the former world football champion afloat is not as doomed to failure as his plan to do the same with the national champion airline would seem to be. Or is Berlusconi simply destined to be a dedicated follower of lost causes? Of course, my status as an ardent supporter and enthusiast for Barça FC is in no way clouding my judgement here.